Manias, Panics, and Crashes

6 ideas

1. Five-stage anatomy of a financial crisis

   A crisis starts with a displacement, an outside shock such as a new technology, a war's end or financial deregulation, which raises expected profits in one sector. Bank credit expands to finance the opportunity and turns it into a boom, then euphoria sets in as buying for resale gains replaces buying for use. When insiders start taking profits, prices stall and the market enters distress, then revulsion, a rush from real or long-term assets into money that becomes a panic.

2. Credit expansion is endogenous to the boom

   Speculative manias are fed by an elastic supply of credit that grows from inside the system and cannot be capped by fixing the money stock. Whenever authorities restrict one form of money, the market invents new ones, such as bills of exchange, bank deposits, call loans or derivatives, so monetary control always lags behind the mania.

3. Lender of last resort paradox

   A central authority should lend freely in a panic to stop a liquidity crisis from becoming a chain of insolvencies. But if markets know the rescue is certain, they take more risk and the next mania grows larger. Its credibility rests on being willing to act without being expected to.

4. Swindles surge at the peak of booms

   Fraud and embezzlement grow during euphoria because rising prices hide them and investors stop doing due diligence. They surface in distress, when the loss of wealth sends people looking for money that turns out to be missing. The exposure of a swindle often sets off revulsion, which makes fraud a signal of the peak as well as a symptom of it.

5. Rational individuals, irrational crowds

   Each participant in a mania may act rationally, for example by buying an overpriced asset in the hope of selling it to a 'greater fool' before the crash. Taken together, these choices produce an outcome that is irrational for the whole group. The analysis should therefore look at how incentives, herding and time horizons interact, and not just ask whether investors are smart.

6. Crises propagate internationally through linked markets

   Manias and panics spread across borders through arbitrage in commodities and securities, gold and capital flows, and shifts in investor confidence. A collapse in one financial center pulls liquidity out of others. This creates the case for an international lender of last resort, a role that historically fell to whichever hegemonic power was willing to take it on.

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